The futures market (part 2)

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The futures market (part2)

In the last editorial I said:

There are two types of futures contracts that are traded in this market.

  • Any commodity that can be seen, touched, and exchanged physically.
  • Financial contracts that deal with interest rates, foreign exchange, shares, government bonds and indices to name a few.

They are used by actual physical traders who want to hedge against price fluctuations and also provide a market for speculators to trade them.  The physical traders use the market to hedge and lock any prospective profit today knowing the current price but avoiding the uncertainty of the future.

Today I will describe the difference between hedging and speculating in the futures market.

Hedging involves taking an offset (opposite) position in a futures contract in order to offset any profit or loss against the underlying commodity. By hedging we try to eliminate or at least reduce the risk that comes through the volatility experienced with commodities.

If we think that a commodity used in production is likely to rise in price (detriment to our profit), we may buy a futures contract in that commodity, so that the price gain will offset the increase cost of production. That is hedging.

Speculators will bet on an outcome for a particular commodity. They speculate on whether the price will go up or down. As this may be considered as betting on an outcome, speculators do not always make money and are risk takers.

Overall, hedgers are seen as risk averse and speculators are typically seen as risk lovers. Hedgers try to reduce the risks associated with uncertainty, while speculators bet against the movements of the market to try to profit from fluctuations in the price of securities.